Fortinet, Inc. — Q3 2023 Form 10-Q
Reporting period: Three and nine months ended September 30, 2023. Fortinet is a global cybersecurity company focused on secure networking, SASE, and security operations (SecOps); it reports one operating segment. Figures below are in U.S. dollars.
Financial performance
| Metric | Q3 2023 | Q3 2022 | Change |
|---|---|---|---|
| Revenue | $1.335 billion | $1.150 billion | +16% |
| Product revenue | $465.9 million | $468.7 million | -1% |
| Service revenue | $868.7 million | $680.8 million | +28% |
| Gross margin | 76.2% | 75.4% | +0.8 percentage points |
| Operating income / margin | $303.2 million / 22.7% | $265.5 million / 23.1% | Income +14%; margin -0.4 points |
| Net income attributable to Fortinet | $322.9 million | $231.6 million | +39% |
| Diluted EPS | $0.41 | $0.29 | +41% |
| Billings (non-GAAP) | $1.491 billion | $1.411 billion | +6% |
| Operating cash flow | $551.2 million | $483.0 million | +14% |
| Free cash flow (non-GAAP) | $481.1 million | $395.2 million | +22% |
Service growth reflected security subscriptions (+34%) and technical support and other services (+20%). Product revenue was affected by demand normalizing after a period of elevated growth and backlog returning toward historical levels. Service revenue was 65% of Q3 revenue, compared with 59% a year earlier.
Nine months ended September 30
Revenue was $3.890 billion, up 24% year over year; product revenue rose 16% to $1.439 billion and service revenue rose 29% to $2.451 billion. Gross margin was 76.3%, up from 74.9%; operating income was $855.7 million, up 40%, and operating margin was 22.0%, versus 19.5%. Net income attributable to Fortinet was $836.9 million, compared with $543.5 million; diluted EPS was $1.05, versus $0.67.
Operating cash flow for the nine months was $1.744 billion, compared with $1.203 billion in 2022. Investing activities used $577.7 million, including net investment purchases, property and equipment purchases, and an $8.5 million private-company investment. Financing activities used $660.3 million, mainly for share repurchases and taxes on equity-award settlement.
Liquidity, debt, and balance sheet
At September 30, 2023, cash and cash equivalents were $2.187 billion; short- and long-term investments were $963.7 million; and marketable equity securities were $19.8 million. These totaled $3.170 billion. Working capital was $1.104 billion. Long-term debt, net of discount and issuance costs, was $991.8 million, consisting of $1.0 billion principal in senior notes due 2026 and 2031. The notes have no financial covenants. Management said current cash, investments, and operating cash flow should meet anticipated needs for at least 12 months.
Total deferred revenue was $5.285 billion, up 14% from December 31, 2022. Remaining performance obligations were $5.30 billion; Fortinet expected to recognize approximately $2.66 billion over the next 12 months. Inventory was $467.5 million, up from $264.6 million at year-end 2022.
Material changes, outlook, and commentary
- Sales trends: Management said Q3 billings and product revenue fell below expectations amid slower secure networking growth and sales-execution and marketing-program challenges. It expects near-term secure networking growth may be below historical rates and plans to shift sales and marketing focus toward faster-growing SecOps and SASE over the next several quarters, while continuing secure-networking innovation.
- Margins and spending: Q3 gross margin improved with a higher service mix and service margins, but product gross margin fell to 57.4% from 60.5%, partly due to inventory and purchase-commitment reserves. Operating expenses rose 19% year over year, and operating margin declined. Management expects R&D, sales and marketing, and G&A expenses to increase in absolute dollars year over year during the remainder of 2023.
- Cash needs: Fortinet postponed certain U.S. federal tax payments and expected fourth-quarter 2023 income-tax cash payments of $340–$350 million. It estimated fourth-quarter capital expenditures of $40–$60 million.
- Supply commitments: Non-cancelable inventory purchase commitments were $820.6 million, down from $1.34 billion at December 31, 2022. A $64.6 million liability for commitments exceeding estimated demand was recorded; related expense was $59.3 million for the first nine months of 2023.
- Capital returns: Fortinet repurchased 10.4 million shares for $605.2 million during the first nine months, with $1.42 billion remaining authorized at quarter-end. After quarter-end through the filing, it repurchased a further 11.2 million shares for $613.5 million, excluding excise tax.
- Tax and investment items: Q3 tax benefit was $0.3 million, with a 0% effective tax rate; the nine-month rate was 5%. A tax-rule change reduced the nine-month tax provision by $39.8 million. The Linksys equity-method investment generated a $32.6 million loss for the nine months; Fortinet reported no additional impairment as of September 30, but warned further impairment could occur.
- Risks and contingencies: Key risks include macroeconomic uncertainty and longer sales cycles, channel and distributor concentration, supply-chain exposure and inventory commitments, competition and sales execution, cybersecurity/product vulnerabilities, and geopolitical developments. Approximately 94% of hardware was manufactured in Taiwan, according to the filing. Three distributors each represented at least 10% of Q3 revenue; six distributors together represented 65% of net receivables. Litigation accruals were not material; the Alorica case remained pending with no loss accrual recorded.
The filing does not provide a clear numerical full-year revenue or earnings guidance in the text provided. Management expected service revenue to continue increasing through the remainder of 2023, subject to customer spending, renewals, supply, and other risks.
Important facts for investors to verify
- Whether billings and product demand stabilize as backlog normalizes, and whether the secure-networking slowdown persists.
- Whether the planned shift toward SecOps and SASE improves sales execution without disrupting channel coverage or margins.
- How service growth, deferred revenue, renewals, and remaining performance obligations translate into recognized revenue and cash flow.
- Whether inventory levels and the $820.6 million of purchase commitments remain aligned with demand, and whether reserves or discounting increase.
- The effect of fourth-quarter tax payments, capital spending, and continued repurchases on liquidity and cash balances.
- Distributor credit exposure, Linksys investment performance and impairment risk, and developments in litigation and cybersecurity risks.